This post was provoked by a comment I read in a financial industry publication from Stuart Ritter of T. Rowe Price’s retirement services division.
Ritter said “saving 3% for retirement is like going to the gym for six minutes.” Acknowledging low rates of savings for many retirement plan participants, Ritter’s contention is that just as 30 minutes of exercise should be a minimum daily routine, savings for retirement should also be done at five times his example. Instead of saving 3% of annual salary, most people should save 15%.
I think Ritter’s quote goes a bit too far. There are some people who couldn’t manage a decent quality of life (even without living beyond their means) if they deferred 15% of their income into retirement savings. An important thing to consider when determining how much to save for retirement is how much of the heavy lifting you want to rely on investment markets to do and how much of it can you do by managing a prudent financial life that pays yourself first via retirement savings.
If you are saving just 3% of annual income, investment markets will be forced to do much more of the heavy lifting to get you to a point where you can come reasonably close to replacing your earned income in retirement by combining Social Security and withdrawals from investment accounts.
For the dwindling few (mostly government employees) who will receive an employer-funded stream of pension income in retirement, saving just 3% of income in addition to the pension may actually be adequate for living lean in retirement. For the majority, it won’t – especially if the savings is not invested in aggressively enough over the long-term to generate a meaningful rate of return.
Consider if at age 30 – possibly after paying off student loans and saving for a down payment on a home, a couple (or even a single wage earner) make $80,000 per year and their income grows at 2.5% per year. If they saved 3% of income in a pre-tax employer retirement plan and earned a 7% average annual investment return for 35 years, retiring at 65, they would have $473,846 of savings. This balance, assuming it continued to earn 7% returns for 30 years of retirement could reasonably be expected to generate approximately $1,400 per month of inflation-adjusted after-tax income to age 95. Add that to the average Social Security benefit and the couple (or individual) has to learn to live on a lot less than while they were working.
I think a more prudent minimum retirement savings is 10% of annual income. Apply the same scenario as before with 10% savings (perhaps through both personal and employer match contributions) and the balance after 35 years is $1,457,633 pre-tax. It would have about a 70% probability of supporting $4,400 per month of after-tax spending for 30 years to age 95.
Of course, many people can’t afford to save 10% of their annual income early in their career but they expect to increase their contributions over time. What if someone upped their retirement plan contribution by 1% every two years. They start at 3% for two years, then 4% for two years and so on until they reach 15% of their income for the final 10 years of their career. Would they ever catch up to the person who saved 10% throughout? No. Even though they would have contributed approximately $58,000 more dollars to the retirement plan, saving much more during the peak earnings years, they would end up a bit less than $200,000 behind the consistent 10% saver. This is due to the missed opportunity to have more money growing and compounding returns in the early years.
While saving just 3% of income for retirement won’t sustain the same standard of living as pre-retirement, saving 15% throughout a career could be oversaving for some people, sacrificing a little bit too much today for the opportunity to use it in retirement.
The most important point is to take the time (or hire an independent financial advisor) to determine what amount of savings you will likely need to live on in retirement. This will inform your level of needed savings throughout the remainder of your working life and also be a guide for the appropriate investment strategy.
- What can you do to increase your rate of savings in retirement plans?
- Do you know how much money you need to save today to replace your income in retirement?
~ Gary Brooks, CFP® – Brooks, Hughes & Jones – Partners in Wealth Management – Tacoma, WA